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Informality among Formal Firms and Access to External Finance

February 15, 2008, Roberta Gatti & Maddalena Honorati

Recent research shows that when informality---defined as self-reported lack of tax compliance by firms--is high, access to credit is low. The observed credit constraints most likely relate to the lower value placed on balance sheets and financial disclosure by credit institutions in environments where tax evasion is diffused.

A recent study sheds light on mechanisms through which informality affects access to external financing. [1] Informality is defined here as lack of tax compliance and is measured by the percentage of sales that firms report not to declare for tax purposes. Low tax compliance is in the aggregate correlated with low per-capita income and other accepted measures of informality across countries.

Firm-level data drawn from the World Bank Investment Climate Surveys show that the degree of tax compliance increases with firm size, ranging from an average of 72 percent of sales declared in micro firms to an average of 86 percent in large firms.

Tax compliance is higher inhigh-tech industries, particularlyin metals and machinery, and chemicals and pharmaceuticals where fixed assets are difficult to hide. Tax compliance is lower in more traditional, labor -intensive sectors such as leather, wood, and furniture.

The figure shows average tax compliance in the sample by region and income category. Tax compliance is lowest in Sub-Saharan Africa and highest in Organisation for Economic Co-operation and Development (OECD) countries.

Access to credit relies on a robust “information channel”

When tax compliance is low, the extent to which balance sheets are informative for banks providing loans is limited. As a result, banks are less likely to extend credit.

Estimates indicate that tax compliance is robustly and significantly associated with various measures of access to credit when controlling for firm characteristics such as size, age of the business, export status, ownership, city and industry dummies, manager’s education, sales growth, and net fixed assets.

Table column 1 shows that a 10-percentage point increase in formality is associated with a 2.6 percentage point increase in the chance of obtaining credit, where credit is measured as a 0/1 variable indicating whether the firms has a credit line or an overdraft facility. Effects are about half this magnitude when country fixed effects are accounted for.

There is a robust association between tax compliance and subjective reports that lack of access to credit is perceived by firms as an obstacle. This indicates that our estimates capture, at least in part, credit constraints and not simply a higher demand for credit from firms that—because of their tax compliance practices—have less funds available.

In order to better understand the link between access to credit and formality, the last four columns in the table show data on the effect of formality on the use of both external finance (banks, leasing arrangements, and credit cards) and informal finance (family, friends, and money lenders).

The coefficients indicate that tax compliant firms turn to formal rather than informal sources of financing. Not surprisingly, country fixed effects estimates are larger than ordinary least squares when informal finance is a dependent variable, reflecting the likely negative correlation between development of informal credit networks and enforcement/tax compliance at the country level

The link between credit and formality is stronger in high-formality countries

When average formality at the country level is interacted with firm-level formality, the coefficient is positive and significant. This suggests that firms’ balance sheets are relatively more informative (as a signal of firm soundness) in environments where tax compliance is higher on average.

Conversely, in countries where informality is diffused, tax evasion is less likely to signal firm quality, so banks may develop alternative ways to assess credit worthiness, such as relationship banking.

Results are robust to a wide range of controls and to instrumental variable estimation

One concern with the reliability of the estimation results is that low-quality firms denied credit might use the extra cash from unpaid taxes to finance their activities. Similarly, low tax compliance and lower reliance on credit from informal sources could both be driven by unobservable managerial preference for informality or cutting corners.

However, the inclusion of controls such as sales and past growth (as indicators of firm quality) and asset value (which capture collateral assets) does not affect results. When country-location-size averages of tax compliance are used to instrument for firm-level formality, coefficients are still positive and significant.

Better access to credit is likely to emerge from a blend of policies to improve both the functioning of capital markets and transparency

From a policy perspective, this evidence suggests that policies directed at improving the functioning of formal capital markets alone are unlikely to be fully successful. Complementary policies aimed at decreasing the level of informality and improving transparency—such as simplification of tax codes and increased enforcement—are needed, too.

Researchers

ROBERTA GATTI is currently Social Protection Sector Manager and Lead Economist in the Middle East and North Africa region but was working as a researcher until recently in the Development Research Group (Macroeconomics and Growth Team). Her research interests include informality and labor market dynamics, and human capital development and growth. Email: rgatti@worldbank.org

MADDALENA HONORATI is a research analyst in the Development Research Group (Macroeconomics and Growth Team). Her research interests include firm productivity and its relationship with institutional quality, informality, and ownership structure. Email: mhonorati@worldbank.org

Fajnzylber, Pablo, William Maloney, and Gabriel Montes Rojas. 2006. “Releasing Constraints to Growth or Pushing on a String? The Impact of Credit, Training, Business Associations and Taxes on the Performance of Mexican Micro Firms. World Bank Policy Research Working Paper 3807.